US dollar trusted by big business

By Eswar Prasad

Scarcely a week passes without news about the ascendance of China’s currency, the yuan. However, China has a long way to go before its currency can rival — let alone displace — the US dollar as the dominant global reserve currency.

To be sure, China already plays a significant role in international trade and finance, with major financial centers like London and Frankfurt eagerly lining up for yuan business.

Recent speculation that China’s economy may soon be as large as the US’ has boosted this interest further, causing many to believe that the yuan will soon dominate.

Chinese authorities have launched a raft of reforms aimed at opening the economy and making it more market-oriented and have announced plans to liberalize interest and exchange rates, and continue to ease restrictions on cross-border capital flows.

All of this will strengthen the yuan’s claim to reserve-currency status.

However, China is missing one crucial ingredient: trust.

For currency dominance, China needs more than economic and military might; it requires a more credible set of public and political institutions. This is where the US shines, relatively speaking.

In the aftermath of the global financial crisis, even though the US’ financial markets nearly collapsed, its public-debt levels rose sharply and the US Federal Reserve was forced to undertake massive monetary expansion to support the economy, however the US dollar strengthened relative to most other currencies.

That is because global investors seeking a safe haven turn to US Treasury securities in times of global financial turmoil.

Foreign investors now hold more than US$5.7 trillion of these low-yielding securities, not to mention large quantities of other US dollar assets and the US dollar’s share in global foreign-exchange reserves has held steady since the crisis.

This can be explained partly because the US boasts the world’s deepest and most liquid financial markets.

However, the most important aspect of the US’ currency dominance is the institutionalized system of checks and balances that operates among the executive, legislative and judicial branches of its government.

Trust in US public institutions is rooted in the open and transparent democratic process that underpins them.

Freedom of expression and unfettered media bolster this confidence, not by highlighting the system’s strengths, but by exposing its weaknesses, which can then be addressed by responsive, rule-based mechanisms.

The US government must answer to its citizens, thus it is unlikely to resort to inflationary debt financing.

In fact, about US$4.5 trillion of US federal debt is held by domestic investors, including retirees, pension funds, financial institutions and insurance companies — groups with considerable political clout ensuring no administration would risk allowing inflation to spin out of control.

The US legal system — independent from the executive and legislative branches of government — further supports the US dollar’s global role.

While one might quibble about the complexity of US laws and regulations, it cannot be said that they are not applied relatively consistently.

This contrasts sharply with China’s single-party system, in which the level of government accountability is much lower. Official corruption, for example, has become so entrenched that Chinese President Xi Jinping (習近平) has made it a priority.